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Monday August 22, 2005 - 10:29:14 GMT
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UK consumer price inflation hits record high

Economics Weekly: Economic Research and Analysis: UK consumer price inflation hits record high

Worrying rise in price inflation
The economic commentary this week will focuson the bigger than expected rise in UK consumer price inflation, which took it to its highest rate since it began to be calculated on this basis in 1997. It is now also above its 2% medium term inflation target for the first time since it was adopted some 3 years ago. This event is especially important as the Monetary Policy Committee (MPC) cut interest rates by 0.25% at its August meeting due to weakening economic growth. Further cuts may not be forthcoming if inflation rises further above the 2% target. However, the inflation target is supposed to be symmetrical around a range of 1% either side of 2%, so this may not be a clear cut conclusion to draw.

Inflation rise not just down to oil prices…
What specific factors were behind the annual rise in the consumer price index (CPI) in July?
Of the 10 key categories of the CPI index that contributed to the change in the annual rate in July, only three showed small falls, food prices, down 0.05% due to fresh fruit, and recreation and culture, down 0.04% due to lower package holidays. The official statisticians report that these were outweighed by increases in other categories. With pump prices rising this year compared with falls a year ago, it was petrol prices that drove up transport costs. The price of air and sea travel also rose in July. In total, transport accounted for 0.19% of the 0.3% increase in the annual CPI inflation rate between June and July. Other significant upward effects on the July annual CPI came from furniture and household goods, 0.1%, and from increased bank charges, up 0.07%.

…core consumer price inflation also rising…
In terms of the annual rate of change, it becomes clear, see chart B, that although energy costs are a factor they are not the only one. Admittedly, housing and household services which are showing the strongest annual rise, at 6.7% in the year to July, include electricity, gas and other fuel charges, which are up collectively by 12.3%. But it also includes rents, which are up by 3.9%, services like plumbing etc which are up by 5.3%, and water services, which are up by 13.5%. In short, although clothing and footwear and communications equipment like computers and mobile telephones are down sharply on the year, they are no longer falling by enough to prevent the annual headline CPI inflation rate from rising. This is shown most graphically by chart C, which breaks inflation into goods and services. Although goods price inflation is still very low, it is no longer falling. Indeed, it rose by an annul rate of 0.5% in July, after falling by 0.2% in January 2005. Services price inflation is rising, and was up by 4.5% in July, after a rise of 3.8% in January. In other words, core inflation is up, reflecting continued fast growth in the services side of the economy (growth in that sector is still averaging about 0.8% a quarter, or 3.2% a year). We have estimated annual CPI inflation excluding energy (electricity, gas and other fuels and fuels and lubricants) and food to have been 1.8% in July, well below the 2.3% headline rate. However, this is still well up from 1.1% we estimate was the core CPI inflation in January this year, see chart D.

…economic growth may be a factor…
Factors that may be helping to push up the core rate include a weaker currency (the pound is down by 1% on trade weighted terms in the year to August) and higher import prices, which may be making the downward effect from goods price inflation - much more linked to internationally traded goods than services - less negative than a few years ago and the previous above trend pace of economic growth. This rise in core CPI will make the MPC’s task of meeting the inflation target more difficult. Of course, the target is supposed to be symmetrical, so the MPC should worry as much about inflation when it is below target as when it is above. And a rate of 2.3% in July is still a long way from the 3% level that would mean the MPC has to write an open letter to the Chancellor explaining what is going on and what they are going to do about it. But cutting interest rates when inflation is above target can only be justified by sharply weaker growth, which will weaken inflation in the years ahead so that even if it is above target at present it will fall below it in time.

...making further interest rate cuts less likely
With signs that retail sales may be stabilising, it is not clear that there will be any further interest rate cuts in the UK this year. Meanwhile, consumer price inflation may tick even higher in the months ahead, complicating the MPC’s task even more. Our forecast for August shows a rise to 2.4% in annual CPI inflation. Mervyn King, the governor of the central Bank, who was in the minority of 4 that voted to leave interest rates even further away from his desire ‘to make monetary policy setting boring’.

UK economic indicators
UK data are few this week. Most attention will be on the revised second quarter gdp figures, due on Friday. The estimate is expected to be raised from 0.4% growth to 0.5% growth, on revisions to trade data and after a strong rise of 1.2% in June retail sales. Such an outcome may make it even less likely that the MPC will cut interest rates later in the year.

Trevor Williams, Chief Economist
[email protected]
Lloyds TSB Bank,
Financial Markets
Faryners House,
25 Monument,
London EC3R 8BQ
0207 283 - 1000

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